The federal estate tax is levied on the transfer of property at death. Since the amount of the estate tax liability depends on the value of the property transferred, it is important that the estate not be overvalued. However, as important as it is not to overvalue the estate, you also don't want to risk penalties for undervaluing it. Generally, all property must be valued at its fair market value either at the time of death or on the alternate valuation date (usually six months afterwards).

The valuation of some assets, such as securities, is simple, while the valuation of other assets, such as a business, is often difficult and represents potential risk if done incorrectly. With some assets, the best one can do is to calculate a reasonable estimate of fair market value that can be defended as accurate. Estate tax planning software can be a useful tool for both tracking and valuing an estate's assets. In addition, it might be helpful to hire a professional appraiser, although selecting an appraiser with sufficient expertise is challenging.

It is essential in any discussion of valuing an estate to look at the Pension Protection Act (PPA) of 2006. This Act greatly increases the penalties when there is a substantial valuation misstatement of tax and defines who qualifies as an appraiser.

Qualifying As an Appraiser

According to the 2006 PPA, a "qualified appraiser" is someone who:

Is recognized by a professional appraisal organization or has met the minimum education and experience requirements (determined by the IRS),

Regularly performs appraisals for a fee,

Is experienced (or has verifiable education) in valuing the particular type of property being appraised,

Has not been barred from practicing before the IRS in the three years prior to the appraisal, and

Is not excluded from performing appraisals under the Treasury regulations.

An estate planner can help one decide when an appraiser is needed and is often the one to select which appraiser to use. Furthermore, it is usually the estate planner who provides the appraiser with the information needed for the assessment. The sooner the appraisal can be done after the valuation date, the easier the process will be for the appraiser.

Generally, it is the estate planner who reviews the appraiser's report. The report must be timely, clearly written, and complete. Should the valuation of the estate ever be challenged in court at a later date, the report will be important evidence.

Valuation of Estate Property

All types of property may be subject to the estate tax and needs to be valued. This is true for personal, real, tangible, and intangible property. Generally, the property must be valued at its fair market value. There is an exception for real property, either located on a farm or used in a closely-held business, which may be valued at its basis. This is known as special use valuation. Special use valuation is restricted, however, as it cannot be used to reduce the decedent's gross estate by more than $750,000 (adjusted for inflation).

For estate transfer tax purposes, the definition of "fair market value" is the price at which the property would change hands between a willing buyer and a willing seller, neither of whom has any obligation to buy or to sell, and both of whom have reasonable knowledge of all the relevant facts.

Besides affecting the estate's tax liability, the valuation of the estate property also affects whether the estate can benefit from Code Sections 303 and 6166. Both of these code sections apply when an estate contains a closely-held business interest, but only if such interest is more than 35% of the adjusted gross estate. Section 303 treats the redemption of closely-held business stock (when used to pay certain estate expenses) as a sale or exchange (rather than dividend treatment). Section 6166 extends the time for paying the estate tax attributed to a closely-held business interest.

An Incorrect Appraisal

So what happens if an appraisal is incorrect? While you don't want the estate to be overvalued, there can be considerable penalties when an estate is significantly undervalued. Again, we must look at the provisions of the Pension Protection Act of 2006, which significantly increased the penalties that can be assessed when there is a substantial misstatement of the estate (and gift) tax. For estate tax returns filed after August 17, 2006, understatements of tax on which penalties may be assessed are now defined as follows:

A substantial understatement is considered to have occurred if the valuation is 65 percent or less of the correct value (i.e., it is at least 35% wrong). Previously, a substantial understatement was deemed to have occurred if the valuation was 50 percent or less of the correct value.

A gross understatement is considered to have occurred if the valuation is 40 percent or less of the correct value (i.e., it is at least 60% wrong). Previously, a gross understatement was deemed to have occurred if the valuation was 25 percent or less of the correct value.

This greatly increases the risk of having an understatement penalty apply.

Accuracy-Related Penalty

The accuracy-related penalty can be assessed for a substantial understatement of tax and a substantial valuation misstatement. There is a 20 percent penalty, assessed under IRS Code Section 6662, if there is an undervaluation misstatement that results in the substantial underpayment of the estate tax. For the penalty to be imposed, the underpayment must be in excess of $5,000. The penalty is assessed on the portion of the underpayment of tax that is attributable to the undervaluation. When the undervaluation misstatement results in a gross understatement, the penalty is doubled to 40 percent.

The accuracy-related penalty may be avoided if the taxpayer can show reasonable cause and has acted in good faith. When applicable, there must be a preponderance of evidence showing the reliance on another's advice. However, the IRS has eliminated reasonable cause and good faith as a defense to the accuracy-related penalty when there has been a gross valuation misstatement.

Be aware that if any portion of an underpayment is due to fraud, a 75 percent fraud penalty applies to that portion. The accuracy-related penalty will not be applied to any portion of an underpayment on which the fraud penalty is assessed.

Estate Tax Planning Software

Valuing an estate correctly is obviously not easy, but software can help. For example, estate tax planning software can classify, describe and track all of the assets in an estate. This is especially helpful when the number and variety of assets is very large.

Of course, future growth calculations are an important part of successful estate planning. With good software you can enter assumed growth rates to calculate the values at death. Software can let you compare changes in the assumed growth rates and/or the year of death, thereby quantifying these variables.

Estate planning done right can save time, effort, and expense. While you never want to overvalue an estate, undervaluation can cost you as well.

Nancy Faussett, CPA, has over 25 years of tax accounting experience. With BNA Software since October 2001, Nancy serves as in-house expert on fixed assets, depreciation, and various areas of corporate and individual income taxation. Author of the Best Depreciation Guide for Best Software (now Sage), Nancy has also been published in Strategic Finance and the ACT Journal. Previously she was vice president of tax preparation for General Business Services and later worked as a depreciation and tax specialist for Best Software.